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Volume 1: No. 2, July–December, 2009

JFIA

Volume 1: No. 2, July–December, 2009

Table of Contents:

 

Corporate Governance and Misappropriation | Full Article (PDF)
Larelle Chapple
Colin Ferguson
Diana Kang
 
Abstract: This study examines the occurrence of misappropriation-type fraud within Australian listed firms and the relation between the incidence of this type of fraud and a firm's governance strength. We measure governance strength using factors relating to traditional corporate governance, such as board composition, CEO duality, and audit committee composition, as well as factors relating to information technology governance. In our study, we use actual dollar amount of fraud reported by listed companies responding to the 2004 KPMG Fraud Survey as one of three different misappropriation measures and publicly available firm-specific data to measure the other variables in the model. Our study found that where the chief executive officer (CEO) also holds the position of chairperson of the board of directors, the likelihood of fraud increases. We also find that the greater the number of independent directors on the audit committee, the lower the level of fraud. Taken together, these results are particularly encouraging as they provide support for regulatory bodies such as the Australian Stock Exchange (ASX) and the Australian Securities and Investment Commission (ASIC), which place considerable emphasis on the importance of establishing good corporate governance practices. The study provides empirical evidence that employing good corporate governance reduces the risk of the misappropriation of assets.

Keywords: Fraud; Misappropriation; Corporate Governance; Board Structure; Audit committees.

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Board Monitoring, Audit Committee Effectiveness, and Financial Reporting Quality: Review and Synthesis of Empirical Evidence | Full Article (PDF)
Luo He
Real Labelle
Charles Piot
Daniel B. Thornton
 
Abstract: We review and synthesize the results of empirical studies of associations between corporate oversight measures and financial reporting quality (FRQ). We examine two oversight components, board characteristics and audit committee characteristics. For each component, we summarize associations between variables contributing to monitoring effectiveness and three presumptive FRQ monitoring outcomes: (1) ex post consequences of low FRQ, such as financial reporting fraud; (2) earnings management measures, such as abnormal accruals; and (3) perceived informativeness of financial reports, manifest in earnings-returns associations, earnings response coefficients, and analyst perceptions of FRQ. Our classification scheme provides a coherent framework for synthesizing the implications of empirical findings, highlighting the role of different corporate governance variables in enhancing different aspects of FRQ. This synthesis has the potential to inform regulators, boards of directors, and forensic accountants who are concerned with improving the oversight of public corporations and reducing opportunities for managers and others to engage in financial fraud.
 
Keywords: Audit Committees, Board of Directors, Earnings Management, Financial Reporting Quality, Fraud, Value Relevance of Earnings. 

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The Stock Market Reaction to Allegations of Fraud and Earnings Manipulation | Full Article (PDF)
Tom Cook
Hugh Grove
 
Abstract: We examine the stock price reaction to announcements that firms are alleged to be doing fraudulent financial reporting or manipulating earnings, using a sample of firms cited by the Securities Exchange Commission (SEC) in its Accounting and Auditing Enforcement Releases (AAERs) during the time period 1985-2005. We find a total 14% drop in stock price over a three day window surrounding the announcement. Subsamples of firms charged with fraud versus those charged with just earnings manipulation have stock prices drops of 16.64% and 8.51%, respectively, over this same window. There is a total 29% drop in stock price over a 30 day window surrounding the announcement. The post-announcement drift over the 30 trading days following the announcement is a total 7.6% drop in stock price with a negative 12.09% for the fraud subsample versus a negative 5.48% for the manipulator subsample. We also model the cross-section of the cumulative abnormal returns (CARs) using firm specific variables and find that the stock market reacts more negatively for high sales growth companies, for firms with more insiders on their Boards, for firms paying a larger percentage of total executive compensation in the form of stock options, and for firms whose CEO is not the company founder. Finally, we find that the size of a firm’s accounting accruals has no effect on the magnitude of the CAR. Forensic accountants and auditors can check for both financial and non-financial factors in assessing earnings management and fraud possibilities.
 
Keywords: Earnings manipulation, Fraudulent financial reporting, Stock market reactions.

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Earnings Misstatements, Restatements, and Corporate Governance | Full Article (PDF)
William G. Heninger
Yongtae Kim
Sandeep Nabar
 
Abstract: This study examines how the corporate governance characteristics of firms restating previously-reported accounting data change from the initial misstatement to the restatement. We endeavour to obtain insights into the changes that lead to the detection and correction of financial misreporting. By contrast, prior studies on restatements, concerned with the causes of misreporting, have focused their investigations around either the misstatement or the restatement period, but not both. We find that prior to misstatements, misstating firms are more likely to have CEOs who sit on nominating committees, less independent boards of directors, and less independent audit committees relative to control firms. Our results indicate that pre-misstatement agency conflicts are not resolved prior to restatements. Boards and audit committees continue to be relatively less independent at the time of the restatement. We also find that restating firms are more likely to experience CFO turnover. Based on the results, we conclude that the restatements, which constitute an admission and correction of accounting irregularities or material errors, are not attributable to governance improvements in firms.
 

 
The Role of the Auditor in Managing Public Disclosures: Potentially Misleading Information in Documents Containing Audited Financial Statements | Full Article (PDF)
Cynthia Firey Eakin
Timothy Louwers
Stephen Wheeler
 
Abstract: We investigate empirically the incidence of auditor modification of audit reports for misleading information included in other documents containing audited financial statements. Professional standards (specifically, SAS No. 8) require modification of the auditor's report for annual report information considered to be materially inconsistent in content or in manner of disclosure with information contained in the financial statements. Exhaustive data base key word searches for phrases that would be associated with such report modifications did not reveal a single instance in which other information accompanying audited financial statements was considered materially misleading since the implementation of SAS No. 8 (1975). Despite this finding, numerous examples from recent research identify what appear to be potentially misleading disclosures in annual reports. Using examples from these studies, we surveyed CPAs and financial statement users and found that that four of the five issues presented were seen as misleading. More authoritative guidance and/or more awareness on the part of auditors may be in order.
 
Keywords: Auditor reports; Misleading information.

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Forensic Evidence-Gathering Procedures for Employee Stock Options | Full Article (PDF)
Zabihollah Rezaee
 
Abstract: Employee stock options (ESOs), as an integral component of long-term compensation plans, are usually offered to directors, senior executives, and key personnel to provide incentives to improve sustainable performance. The timing of option grant dates could be managed in a manner to increase the potential value of ESOs which would have significant governance, legal, ethical, tax, and accounting consequences. Backdating practices of retroactively setting the grant date as the day when the underlying stock price was low have been scrutinized by regulators. This article examines auditors’ responsibilities regarding ESOs and backdating practices as more than 250 public companies have engaged in backdating practices. Independent auditors should be skeptical of the likelihood of backdating practices of their clients and pay particular attention to the disclosures of ESO plans and grants. Auditors should use appropriate forensic accounting techniques and procedures to ensure investors receive relevant, reliable, and transparent information on ESOs. The fraud triangle should be used by auditors to gather and assess evidence about their clients: (1) incentives or pressure to engage in option backdating; (2) opportunities for backdating practices; and (3) rationalization of their backdating practices of ESOs.
 
Keywords: Employee stock options (ESOs); Backdating practices; Forensic audit procedures; Fraud triangle.

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Public Relations Associates: Investigating Cost Assignment Fraud | Full Article (PDF)
Jennifer Mueller
Brian Ballou
Paul Zikmund
 
Abstract: This instructional case reveals employee misappropriation resulting from control environment failure. Though the company is fictional, the case is based on an actual fraud within a large corporation. Part I of the case describes the controller’s discovery of curious accounting within accounts payable. Students play the role of a fraud examiner who has received a frantic call from the controller. Part I requires students to use the initial information provided by the controller to determine how the investigation should proceed. Part II of the case allows the investigation to unfold similarly for all students, ending with "solving" the case. Part II requires students to write a letter to the Board of Directors containing specific recommendations on how control weaknesses (related to the fraud occurrence) may be mitigated.
 
Keywords: Fraud risk, fraud investigation, forensic, accounts payable, purchasing, case.

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HealthSouth Corp.: The First Test of Sarbanes-Oxley | Full Article (PDF)
R. Loring Carlson
John M. Coulter
Thomas J. Vogel
 
Abstract: In 2003, federal authorities obtained thousands of documents pertaining to the accounting records of HealthSouth Corporation, headquartered in Birmingham, Alabama. The SEC alleged that the Company deliberately overstated its earnings by a total amount of over $2.5 billion. Over a dozen executives pled guilty to various charges in connection with these fraudulent misstatements, and the former CEO, Richard Scrushy, was indicted on eighty-five criminal counts, including three counts under the Sarbanes-Oxley Act. As a result, he became the first CEO of a major company to be charged with violating the Act. PricewaterhouseCoopers, LLP, was contracted to perform a special audit to identify the misstatements in HealthSouth’s publicly issued financial statements for the period 1999-2001, to quantify the impact of those misstatements, and to make recommendations associated with necessary improvements in internal controls in order to reduce the future likelihood of the occurrence of fraud. The report on the special audit provides details on a number of potentially significant deficiencies in HealthSouth’s controls over its financial reporting process. Case questions are designed to have students consider the implications of the Act on the conduct of the audit, as well as to examine the link between weaknesses in HealthSouth’s internal control over financial reporting and the resulting fraud. They are also given the opportunity to draft sample audit reports for different opinions.
 
Keywords: Sarbanes-Oxley, fraud, forensic audit report.

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Behavioral Implications of Evaluating Determinants of Academic Fraud Risk Factors | Full Article (PDF)
Charles A. Malgwi
Carter Rakovski
 
Abstract: In this study, we report how 740 business students rated the relative importance of 35 academic fraud risk factors (red flags) identified in a newly designed academic fraud triangle. We conceptually demonstrate the hierarchy of the relative importance of the academic fraud risk factors using the Analytic Hierarchy Process. A factor analysis was conducted using maximum likelihood estimation with a Varimax rotation solution. One-way ANOVA models resulted in F-tests for differences among the mean factor scores for different groups of students. Pressure was ranked as the most important red flag element, identified by 70 percent of students as the most important element. This was followed by Opportunity (20 percent), while Rationalization was only chosen by about 10 percent of students as the most influential of the three elements. The mean factor scores by gender and domestic and international status of students were not significantly different. However, significant differences existed among respondents by class standing. Specifically, financial, job and social pressures were ranked of differing importance by students across undergraduate and graduate levels.
 
Keywords: Academic fraud, plagiarism, cheating, academic dishonesty and fraud triangle.


Computer-based Proactive Fraud Auditing Tools | Full Article (PDF)
Gary J. Cook
Lynn H. Clements
 
Abstract: Deterrence and detection of fraud has been a concern for a long time, but the collapse of Enron created a new era of concern over the detection of fraud. Fraud auditors have been slow to acknowledge the importance of the numerous computerized fraud detection tools, some of which were developed specifically for fraud investigation, and many which are multi-purpose tools. We have become concerned about the lack of use of the best tools available for fraud auditing. In this paper, we present an extensive number of computerized tools available to fraud auditors, an analysis of the tools currently used by fraud auditors based upon an e-mail survey, and our recommendations for the best tools to use in each of the three phases of fraud auditing based upon our model presented herein.
 
Keywords: Fraud, fraud auditing, computerized tools, forensic techniques, forensic tools, and fraud audit model.

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